Highlights

    • The outlook for U.S. monetary policy will depend as much on bank behaviour as on the labour market. Since incoming data have yet to show a change in bank lending or significant growth in employment, we are pushing back our forecast for the first Fed rate hike to August 10 from April 28.
    • Although we think a gradual but early exit strategy would be well advised, Mr Carney will have the last word. Still it is only a question of time before short term rates will be driven up by the Bank. The longer the Bank wait the steeper will be the raise afterward. In any case we are expecting the overnight rate to stand above 2% by Q1 2011.

    One eye on jobs, the other on banks


    Though U.S. economic indicators suggest strong fourth-quarter GDP growth, the employment reports continue to disappoint. The payroll survey showed a loss of 85,000 nonfarm jobs in December. The household survey showed substantial drops in employment and in the labour force, suggesting that the lack of change in the  unemployment rate did not fully reflect the weakness of the labour market. The report for December was not all bad. November payrolls were revised up to a gain of 4,000, the first monthly rise in 23 months. Temporary-help supply agencies added 46,500 jobs in December, the fifth consecutive monthly increase. Such hiring by temp agencies is a leading indicator of meaningful payroll gains. On this point, it should be kept in mind that only a third of the $787-billion stimulus provided by the American Recovery and Reinvestment Act of 2009 (ARRA) has been spent so far.

    According to the Congressional Budget Office, the direct and indirect economic effects of ARRA will peak in the first half of 2010, coinciding with substantial hiring for the 2010 census. So despite the December jobs report, we remain optimistic about the U.S. economy and labour market. We expect GDP growth of 4% annualized in each of the next two quarters.

    That said, we recognize that the slow pace of improvement in the labour market so far means the Fed will tend to wait longer than we previously thought before raising interest rates.This is especially true in that inflation appears unlikely to pose a threat anytime soon. Unit labour costs are currently disinflationary. Shelter costs – 42% of core CPI – were little changed in December. Core CPI rose 1.8% in 2009. Alternative measures of trend inflation such as the 16% trimmed-mean CPI were even tamer at 1.3%, and have shown no acceleration over the last three months.

    On a two- to five-year horizon the inflation prospect is less certain. The Fed has made massive volumes of liquidity available to get credit markets past the financial crisis. Since inflation is a monetary phenomenon, the Fed’s timing of its exit from pedal-to-the-metal monetary stimulus must take into account not only the job market but what banks are doing with that liquidity. In the third quarter, persistently high loan losses kept the banks risk-shy. At year end, commercial and industrial loans on bank balance sheets were still shrinking and home foreclosures were still high. So far, banks have been happy to hold large excess reserves on deposit at the Fed. If that situation were to change with strengthening of the economy, the Fed would have to adjust its stance rapidly. Thus the outlook for monetary policy depends as much on bank behaviour as on the labour market. This is not a new phenomenon. After each of
    the last two recessions, the beginning of Fed tightening coincided with a turnaround in bank lending.